Irrational Exuberance by Robert J. Shiller

reviewed by Dr. A. J. Senchack
Department of Economics and Business

Can the stock market’s current “irrational exuberance” be perfectly rational? Some say it’s just the normal working of demand and supply. At the other extreme, others say the stock market is crazy, unbelievably dangerous, and captive to mass investor euphoria that outruns common sense. Yale economist Robert J. Shiller agrees with the latter group. In Irrational Exuberance , his New York Times best seller, Shiller persuasively argues that we are in a speculative bubble, “…a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.” His main purpose: to warn individual investors that stock prices are dangerously overpriced and investments in stocks should be reduced. His apocalyptic prediction: a catastrophic collapse and worldwide economic hardship is soon to follow, much like The Great Crash of 1929 heralded the 1930s Depression era.

Shiller’s latest read is not your typical doom and gloom book, like so many others that feed on people’s innate fear and greed. Rather he documents his controversial arguments with convincing historical and statistical research that avoids the arcane. He successfully draws parallels with three earlier eras, 1902, 1929, and 1966, when a speculative fever spread among investors, and describes the psychological, and often irrational, influences that infected these eras’ financial markets. Not surprisingly, they sound a lot like today’s TV talking heads and their news headlines.

He also crafts his theoretical arguments with a blend of psychology, sociology, and economics. Three factors conspire to levitate stock prices—behavioral, cultural, and structural. The main psychological culprit in overheated prices is “herd behavior,” that inexplicable tendency for individuals to substitute crowd thinking and overly optimistic expectations for independent judgment and more sane behavior. When he turns to cultural factors, Shiller harshly criticizes the news media for fast-breaking sound bites. Where else but the stock market can they find a story that can be reported every minute on TV and every day in the newspapers?

Finally, “precipitating” factors in our new era economy, such as the arrival of the Internet and its dot-coms, microprocessor technology, wireless communication, and demographic shifts serve as structural underpinnings for the current bubble-inflating process. But Shiller regards a second kind of structural factor as more critical. This “amplification mechanism” amplifies these current events by creating a self-sustaining circle of rising investor confidence, starting from the precipitating events, which, in themselves, bear little significance for explaining inflated stock market values.

I was attracted to this book by my fascination with investor psychology and how information is processed by investors. Dr. Shiller’s research is well known in this area, and he is famous for stressing the importance of psychology in financial markets. In fact, he is one of the lone voices who helped found a new field in finance called behavioral finance, a blend of psychology and finance. The big question, though, is whether Shiller is right in forecasting a grim decade of stagnation or decline in stock prices. The answer depends upon whether the New Economy is truly different from prior eras and whether it will continue to produce super gains in productivity and profits.